The home office deduction is limited to the business activity’s gross income, but many people mistakenly believe that the limitation is the activity’s net income. The gross income limitation is actually the gross sales less the cost of goods sold, the business portion of the home’s mortgage interest and taxes, and the otherwise deductible business expenses that are not related to the home’s business use. (Publication 587 includes a worksheet on this calculation.)
There is also the choice between the regular home office calculation and the simplified method. The simplified method does not include home mortgage interest and taxes, which are fully deductible on Schedule A. That changes the computation above so that the mortgage interest and taxes are not included in the limitation computation; as a result, the deduction limit increases to $4,000. However, under the simplified method, the maximum home office deduction is limited to 300 square feet at $5.00 per square foot, for a maximum of $1,500. It is conceivable but uncommon for the simplified method to generate a higher overall limit. Therefore, in most circumstances, the gross income limit will be higher than that of the simplified method, but the overall deduction may still be higher using the actual expenses method because of the simplified method’s $1,500 cap (which can be even lower depending on square footage).